In a market dominated by electronic trading, investors are having their pockets picked—and individual investors and mutual fund shareholders are among the likely victims.

The securities exchanges' practice of selling early access to their trading data to insiders—as the term "insiders" suggests—is a practice that looks like illegal insider trading (I also use the term in place of HFT because, as former SEC Chairman Arthur Levitt has noted, not all HFTs are predatory).

Broad policy questions about high-frequency trading will be on the regulatory agenda for years to come. However, the next major development is likely to go to the narrower question of what is legal and whether government lawyers will have a way, and the will, to prosecute, as they did Galleon Group founder Raj Rajaratnam.

In fact, Attorney General Eric Holder told lawmakers on Friday the Justice Department is investigating high-speed trading for potential insider trading. "I can confirm that we at the Justice Department are investigating this practice to determine whether it violates insider trading laws," Holder told a House panel at a hearing on the Justice Department's budget.

Insider trading occurs when a person trades on material (important), nonpublic information in violation of a legal duty. The trading data is nonpublic, the exchanges have a legal duty not to disclose the data before sending it to investors, and the huge profits that insiders reap from trading on early access strongly suggests the data is important.

Lobbyists and others have defended direct insider feeds on the grounds that advance access improves liquidity and price transparency, the practice is widely known, and anyone can buy the inside information.

All may be true, but none is a defense to insider trading—they are no more relevant to insider trading claims than conventional insider trading cases. Billionaire Raj Rajaratnam's insider trading may have improved price transparency, but there is a reason that he is in jail and not making appearances on CNBC. The fact that anyone could have bought the inside information that Rajaratnam bought is (obviously) equally unavailing.

Another defense is that everyone is doing it. As demonstrated by the Nasdaq market manipulation scandal of the 1990s and the mutual fund market timing and NYSE specialist scandals of the 2000s, "everyone is doing it" is not much of a defense, either. All of those scandals ended in numerous, successful (and a few unsuccessful) prosecutions and settlements. Meanwhile, defenders of the sale of direct insider feeds have studiously avoided the insider trading question.

The early bird catches the trade

The exchanges also appear to be violating rules under the National Market System (NMS).

In order to ensure that everyone has equal access to and can rely on the best bids and offers (NBBOs), NMS Rule 603 prohibits the sale of trading data on terms that are not "fair or reasonable" or "unreasonably discriminatory" (this is the legal duty for insider trading purposes). Advance access renders the terms on which everyone else receives the NBBO data unfair, unreasonable, and unreasonably discriminatory. In the words of one academic, "The exchanges benefit from essentially selling the same data twice, albeit at different speeds."

In 2012 the SEC sued the New York Stock Exchange (NYSE) for violating Rule 603 by sending its best quotes and trade prices to purchasers of its direct insider feed before it sent the data to the Securities Information Processor. The SIP receives trading data from exchanges, processes it to determine the current NBBO and disseminates the NBBO to about 2.5 million subscribers.

Commentators refer to the SIP as if it were neutral party, but it is actually controlled and operated by the same exchanges that are selling the direct insider feeds—the exchanges determine when the NBBO is sent to subscribers, which enables the exchanges to ensure that insiders receive the trading data first.

Since the SEC's enforcement action against the NYSE, exchanges have continued to provide advance access to trading data to insiders, which is illustrated in the following example.

There is no way to understand this without being willing to slog through the trading details.

At 3:50 on Dec. 20, 2013, the transmission of quotes for certain Nasdaq-listed stocks to the SIP experienced a six-second delay. In the chart above, the vertical blue blocks show the quote spread for Activision Blizzard over an 8-second interval as they were received by subscribers to the SIP. The top of the blue lines is the best offer, and the bottom is the best bid. The area in between reflects the spread between the two.

For example, just shy of 1 second after 3:50, the best offer was about $17.81, the best bid $17.68 and the spread about 13 cents. The last best offer before the delay was $17.74 (it appears in the red circle, higher in the chart because it declined to $17.74 only in the last few microseconds before the delay).

The blank, 6-second gap reflects a period during which SIP subscribers did not receive quotes for Activision and other affected stocks. Quotes continued piling up on Nasdaq without being submitted to the SIP (other exchanges' feeds did not experience the delay).

Time travel

The problem begins with the time stamp on the SIP quotes. When the delayed quotes arrived at the SIP, they were given a fresh time stamp at the time SIP sent them out. In other words, each delayed quote received the same time stamp, notwithstanding that the actual time of some quotes was up to six seconds earlier.

The SIP time stamps aren't just false when delayed—they are always false. The SIP applies a time stamp that is always later than the actual time of the quote, generally by the millisecond or two it takes for the quote to travel from an exchange to, and be processed by, the SIP. The trading advantage enjoyed by insiders is larger than subscribers may be led to believe.

The exchanges have structured their transmission systems to ensure that if SIP subscribers' feeds are delayed, insiders' feeds will continue uninterrupted, thereby multiplying the insiders' already significant trading advantage. This structure is described in the SEC's enforcement action against the NYSE, which explained how the NYSE created one line for insiders and another line for the SIP. In the SEC's words, the NYSE designed the insiders' line "to operate independently" to ensure that the "proprietary feed was not affected when delays were experienced by the NYSE system that sent data to the Network Processor."

The exchanges openly advertise their direct insider feeds as providing data in "real time" with reduced or no "latency." Reduced latency is a euphemism for early access. As the NYSE explains, its OpenBook Ultra direct insider feed's "microsecond resolution and internal matching engine time stamps provide comprehensive latency visibility to customers."

In other words, the NYSE provides the correct time stamp and advance access on a microsecond basis (1 thousandth of a millisecond) to insiders who pay millions of dollars for this service.

The direct insider feeds are not the only source of advance access to material, nonpublic trading data. Exchanges also offer co-location services, whereby insiders purchase space on servers in a warehouse where the exchanges keep their servers. The insiders' physical proximity further increases their time advantage over other investors. As the NYSE describes its co-location service: "Colocation has emerged as a highly desirable service for latency sensitive financial trading firms seeking to gain microsecond benefits when trading in today's competitive electronic markets."

While creating a structure that ensures that SIP subscribers will be treated unfairly, the exchanges go to great lengths to ensure that co-located insiders do not gain an unfair advantage over other co-located insiders by being parked a few feet closer to the exchange's servers. For example, the Chicago Mercantile Exchange's co-location facility promises "equidistant cabling" "to ensure location neutrality for all customers."

Take the money and run

The important thing for investors is putting a dollar figure on the gains realized by insiders at their expense. The stale best offer of $17.74 per share that SIP subscribers saw during the six-second delay occurred while bid quotes on various exchanges quickly passed the $17.74 mark. SIP subscribers did not know this. Insiders did. With advance notice of the rising quotes, insiders would have bought shares at $17.74 from SIP subscribers when the insiders knew that there were higher bids at which the subscriber could have sold their shares.

Investors are routinely fleeced when insiders receive advance notice of trading data that enables them, for example, to trade at the stale NBBO when they know that a higher bid or lower offer is on its way. Insiders profit even when the NBBO is stale by only a few milliseconds, which is typical, because they can act on trades in fractions of those milliseconds.

The exchanges will not disclose, of course, which investors had their pockets picked in the middle of the afternoon on Dec. 20, 2013, but we know who they might have been: Mutual funds, pension funds, companies repurchasing their shares, company executives selling shares and individual investors are all likely candidates.

Only the exchanges—the architects that are paid for creating and maintaining the insider trading scheme's structure—can tell us who absconded with the various Activision stock sellers' money.

Michael Lewis has said of high-frequency trading that "[i]f it wasn't so complicated, it would be illegal." Some HFT practices are illegal, so it might be more accurate to say that "if it wasn't so complicated, it would be prosecuted." First, the exchanges have a viselike grip on the data, a position that HFT lawyers stand ready to (confidentially) defend. Federal prosecutors will have great difficulty bringing cases without access to data and the assistance of the exchanges to analyze it.

Second, regulators may be reluctant to prosecute predatory HFTs. These practices have been going on for years, but the financial crisis may have put market manipulation on the back burner. The kinds of market abuses in which some HFTs engage are very similar to those alleged in a series of cases against NYSE specialists that resulted in a record string of losses for federal prosecutors, which may have left them chastened.

Critics of HFTs lack confidence in the SEC. They believe the SEC incorrectly blamed the flash crash of 2010 on a mutual fund firm (ironically, mutual fund firms are the largest victims HFT-related abuses). To be fair, the SEC report places much of the blame on HFTs. In contrast, the CME self-servingly found that HFTs "may have had the effect of providing a buoyant function in the market." Critics also note that the SEC hired an HFT firm to create its Market Information Data Analytics System (MIDAS), which one Congressional witness described as the "fox guarding the henhouse."

Critics complain that Gregg Berman, head of the SEC's Office of Analytics and Research, previously worked with hedge funds and HFTs. My reading of Berman's statements suggests a strong emphasis on efficiency that may reflect—with the emphasis on may—a non-lawyer's view of the legality of insider trading. It would help clear up any doubts regarding his position if he (or better, SEC Chair Mary Jo White) made an explicit public statement in support of the SEC's own NYSE enforcement action and confirmed the fundamental illegality of the exchanges' selling advance access to material, nonpublic trading data to insiders.

Bullard, a former SEC official, has testified before Congress on securities regulation issues on more than 20 occasions. He is an MDLA Distinguished Lecturer, Associate Professor of Law and Director of the Business Law Institute at the University of Mississippi School of Law; founder and president of investor advocacy group Fund Democracy; and vice president at financial planning firm Plancorp. The graphic in this article was provided by Eric Hunsader, founder and CEO of Nanex.